State and local business taxation: Is there a better way?

Chicago Fed Letter, Dec 2004 by Mattoon, Richard

Over 80 academics, business leaders, and public policymakers came to the Federal Reserve Bank of Chicago on September 13, 2004, to explore how state and local governments tax business. The conference, which was co-sponsored by the National Tax Association, examined proposals to improve business tax efficiency and equity.

In welcoming remarks, Charlie Evans, Chicago Fed senior vice president and director of research, provided the following description from a mid-twentieth century article on business taxation: "At best it is the disordered product of fiscal expediency and piecemeal legislation-a more or less accidental conglomeration of tax laws, enacted at different times and applied to different businesses or different attributes of the same business, according to the exigencies of the moment."1 Evans noted that although this article was written in 1940, one could argue that the description still applies today.

Fred Giertz, executive director of the National Tax Association, noted that many advocate for the abolition of corporate income taxes. However, it is difficult to see what tax base might replace this revenue source.

State and local business tax burden

Tom Neubig from Ernst & Young and president of the National Tax Association presented joint work identifying the total state and local tax burden on business.2 His study measures the effects of property taxes, sales taxes, excise taxes on business inputs and investments, franchise taxes, gross receipts taxes, as well as unemployment insurance, workers' compensation, and business license taxes. The study finds that businesses paid $404 billion in state and local taxes in fiscal 2003, accounting for 43% of state and local tax receipts.

In terms of (state and local) revenue raised by type of tax, 39% of business tax receipts derive from the property tax. The sales tax on business inputs is responsible for 25% of the total, while the corporate income tax raises only 9%. Neubig noted that roughly 67% of state and local taxes fall principally on capital-at least initially-before the burden can be shifted into prices or elsewhere. Neubig also presented estimates of state and local taxes across industries as a percentage of industry value added. For all industries, the tax share of value added was 3.8%, with the bulk falling on capital. The rates varied widely across industries, ranging from a high of 8.2% in agriculture and mining to a low of 2.2% for services. Finally, Neubig argued that policymakers should consider total business taxes and determine the economic incidence of business taxes (how much falls on resident versus non-resident consumers, capital owners, and workers and landowners) and whether the tax burden is proportionate to the public services that businesses consume.

Is there a better way to tax business?

William Oakland, professor emeritus from Tulane University, suggested that business taxes should recoup the cost of providing public services to businesses. Taxation should also be firm specific-the business tax burden should vary directly with each firm's production activity and government services consumed.

In this way, the tax burden acts as a price signal for firms, voters, and state-local governments. Applying the benefits principle would: reduce windfalls to the private sector; promote locational neutrality; promote production efficiency; and promote better political decisions by revealing the real cost of public services and any cross subsidy paid by business.

This system would require identifying and apportioning the public services provided to businesses. At the top of the list, Oakland said, unemployment compensation represents a direct benefit service to the business community and should be fully paid for by business taxes. Many public services are designed to benefit both consumers and businesses, such as public safety and transportation, and these costs could be apportioned between the two sectors. Oakland argued that safety net expenditures and educational expenditures should not be funded by business taxes. Because businesses compensate workers for the cost of their education with higher wages, taxing businesses directly to pay for education would amount to double taxation. In a 1995 study, Oakland and his co-author William Testa of the Chicago Fed argued that businesses should be responsible for funding 16% of tax-financed state and local combined expenditures.3 However, they estimated that 38% of state and local expenditures were actually supported by business taxes.

Oakland recommended the adoption of two different tax structures. On the state level, the corporation income tax and the sales tax on business purchases should be replaced with an origin-based value added tax (VAT). This would apply to all forms of economic enterprise, including service firms and non-profits (since even nonprofits use public services) and would create a large, non-distortionary tax base. At the local level, the reliance on the property tax should be balanced by a local earnings tax, and business property taxes should exclude payments to schools. Oakland concluded that this structure would promote efficiency and identify the true cost of public services.